The world was shocked after Russian armour rolled over the Ukrainian border on February 24. Few had expected Russian President Vladimir Putin to actually go through with the implied threat of the military build-up that was first reported four months earlier. The obvious consequences, the extreme sanction regime that had been threatened, made such a move unimaginable. Yet Putin did it anyway.

And the sanctions were harsh. Indeed, they were even harsher than anyone, including the Kremlin, had expected. If Putin was banking on the EU staying true to form and dithering over details while interest groups within the Union lobbied to protect their special interests, that didn't happen.

Up until the last day before the invasion Germany was extremely reluctant to say that the Nord Stream 2 gas pipeline would be included in the package and earlier said that a ban on the SWIFT money messaging service was also off the table, according to a report in Handelsblatt. The day after the invasion both sanctions were imposed first, not last.

However, it was the sanctions on the Central Bank of Russia’s gross international reserves (GIR) on February 27 that really came out of left field. This idea had never been suggested at any time since the sanction regime appeared following Russia’s annexation of Crimea in 2014. And the Kremlin seems to have been caught totally unawares by the move that has frozen some $300bn – half of all the money it had accumulated in Putin’s fiscal fortress that was designed to sanction-proof Russia.

The impact of freezing the central bank’s money is still not clear but it immediately threw Russia’s financial system into turmoil. The regulator scrambled to impose capital controls and husband what resources it still had available. The ruble crashed and long lines appeared outside banks as ordinary Russians raced to get what was left of their savings out of the banks. A financial collapse was avoided, but only narrowly.  

In effect the West has declared economic war on Russia. EU President Ursula Von der Leyen specifically said in the last days of February that the sanctions were designed to “degrade the Russian economy.” They are not a diplomatic tool to be used in negotiations to persuade Russia to change its ways. They are designed to do as much damage to the Russia economy as the West is able to do. And Brussels still has plenty more ammunition to fire. A fifth packet of sanctions is due to be discussed in April to close down the loopholes the fourth packet missed.  

One obvious example is that although Europe had taken control of half Russia’s reserves, the latter still has $136bn of physical gold in Russia out of Brussels and Washington’s reach. In late March the US tabled new secondary sanctions on any business, trader or bank that enters into a gold deal with Russia in an effort to lock up this block of money as well.

And more sanctions on Russia’s oil and gas business are very likely, particularly after the shocking reports of a massacre in Kyiv’s suburb of Bucha on April 3, where retreating Russian soldiers murdered a reported 350 civilians in cold blood. Lithuania has already stopped Russian gas imports and the rest of Europe is likely to follow as soon as it is economically possible. As Russia exports some 70% of its gas to Europe, it has almost certainly lost a business that earned $146bn in 2021 forever.  

Even if Russia’s "special military operation" ends tomorrow, its consequences will almost certainly remain with the country for a long time. But the questions are how bad the effect will be, how leaky the sanctions are, and to what extent can Russia re-orientate its economy away from the West and make a new life in the company of the Emerging Markets (EMs).

Limits on the sanctions regime

An easing of large-scale economic sanctions is possible, but unlikely in the short term, the programme director of the Russian International Affairs Council and Russia's most authoritative expert on sanctions, Ivan Timofeev, explained in an op-ed for Izvestia.

From a technical point of view, these sanctions can still be lifted quickly and easily. British Foreign Secretary Liz Truss said on March 31 that if Russia ended the war now the UK would consider lifting some of the sanctions as an incentive.

Unlike the previous Jackson-Vanik trade sanctions imposed in 1974 on the Soviet Union that were legislated by the House, these sanctions have been executed by US Presidential executive order. The difference is that any sanctions that have been put in place by Congress need a vote in Congress to undo them – almost impossible to get. However, US President Joe Biden is in a position to overturn the current sanctions at his sole discretion at the stroke of a pen.

Removing the EU sanctions would be a lot harder, as it requires a unanimous decision by the EU Council. Disagreements may arise here, but it is easier to overcome them than in the US Congress, according to Timofeev. Like in the US, in the UK the executive branch has a fairly wide manoeuvre room in modifying the sanctions regime, so technically their significant reduction is simple.

A second problem with the current regime is that while they have struck at Russia’s money and business they remain limited. For example, while Russia’s two biggest banks, Sber (formerly known as Sberbank) and VTB Bank, were immediately banned from the SWIFT system and together account for about half the Russian banking sector by assets, only a total of seven from Russia’s 374 banks have been banned from using SWIFT.  

In particular, the financial arm of Russia’s gas champion, Gazprombank, has specifically excluded from the ban so that it can accept payments for gas exports to Europe. This has left a huge hole in the financial sector and gas trade sanctions that sees billions of dollars a week pour into Russia’s coffers and long-term will leave a very serviceable conduit into the global financial system that the Kremlin can use more of less unfettered.

Moreover, at the end of March Russian President Vladimir Putin announced a rubles-only-for-gas scheme where EU customers would be forced to pay for their gas imports using Russia’s national currency. While at first glance this appears to be a pure accounting trick that makes little difference to Russia’s economy or the value of the ruble, it actually blows a hole in the sanctions regime by making it impossible to sanction Gazprombank or freeze the gas payment funds.  

A third problem is that not everyone has signed up to the sanctions regime. It remains an almost exclusively G7 affair, championed by the US, UK and EU. During the UN General Assembly vote on March 3 to condemn Russia’s invasion of Ukraine 141 countries voted for the motion but 35 notably abstained. Most of Africa and all of Central Asia, India and China all sat on the sidelines. The Middle East voted to condemn Russia, but their sovereign wealth funds working in Russia have only “suspended” business while the war continues. Latin America, where Russia has many friends thanks to both the BRIC organisation and its open support of Venezuela in its show down with the US, can also be relied on for help.

Russia has been working actively to develop deeper ties with the EM world and won much goodwill and kudos during the coronavirus (COVID-19) pandemic by being generous with its Sputnik V deliveries, while the developed world hoarded their own vaccines for their own use before releasing them to the rest of the world in what has been dubbed “vaccine apartheid.”

How bad will sanctions be?

The jury is still out on how bad the effects of the sanctions will be. The economic impact is just starting to make itself felt in Russia with mixed results.

The immediate impact on the economy has been hard as the war and the financial sanctions have already impacted business with new supply chain disruptions. In addition to the widely published sugar shortages, other basic inputs have disappeared such as supplies as simple as office paper, which is largely produced in Finland.

In one of the first indicators the S&P Global Russia Manufacturing PMI tumbled to 44.1 in March 2022 from 48.6 in February – the second straight month of contraction in factory activity and the steepest fall since the start of the coronacrisis in May 2020. Production slumped as new orders fell and foreign and domestic client demand was muted. Also, employment shrank the most in nearly two years, while backlogs of works dropped at the fastest rate so far this year.  

Unemployment is bound to rise. During the coronacrisis unemployment soared to a maximum of 6.3% in August 2020 from a post-Soviet low of 4.3%, but fell quickly back to its previous low after the vaccines appeared. This time round unemployment is forecast to rise to 7.1%-7.8% and stay there. The government is working hard to mitigate the rising in joblessness with a RUB1 trillion social spending package – basically the same package it used to cope with the coronacrisis – and hopes to keep this number down.  

Inflation is going to be a problem too and was already a problem before the war started. The PMI panellists reported the rise in selling prices in March were the steepest since the series began in January 2003 and sentiment, that had been buoyant in October before the tensions appeared, dropped to its lowest in 22 months.

However, the Central Bank of Russia (CBR) has done an impressively good job at managing what is the biggest shock to the economy since 2008 and 1998, the last two really big crises.

The CBR immediately brought in a 10.5% rate hike after war started and closed the currency exchange, bond and stock markets. The ruble exchange rate blew out from around RUB80 to the dollar pre-war to a peak of RUB134, its weakest level ever, but in the weeks that followed with strict capital controls, an 80% surrender requirement on exporters earning foreign exchange and a bit of judicious intervention, the CBR managed to engineer the ruble’s recovery to back under RUB90 and pre-war levels.

The upshot was to persuade the population to stop withdrawing their money from Russia’s banks and even return it to long-term deposits accounts, thus stabilising both the currency and the banking sector. Similar operations were carried out with the domestic bond market and then the stock market where a combination of restrictions on trade, a ban on short selling and some liberal spending of funds have also stabilised both those assets markets. These were temporary measures and it remains to be seen where the markets will settle once all the restrictions are removed and foreign investors are allowed to participate in the markets again, but CBR Governor Elvira Nabiullina has certainly considerably limited the damage.

There is also relatively good news on the inflation front, where the recovery in the ruble exchange rate will take off the inflationary pressure and at the same time the emergency rate hike to 20% is also having an effect. On March 31 Rosstat released its weekly inflation figures that suggest that inflation has fallen back from 20% to 15% on an annualised basis, leaving a 5% real return on the CBR rate that is also coaxing Russians to return money to the banking system.

Nabiullina must be one of the most experienced central bankers in the world when it comes to coping with financial crises and has done a sterling job, but the 20% prime rates are a growth killer and it took the CBR some seven years to unwind the last emergency rate hike to 17% in the 2014 oil price shock and it should take equally long to unwind this one.

However, the real damage to the Russian economy is the shackling of Russia’s growth potential. Since Putin started preparing for the current war in 2012 when he diverted every spare kopek to modernising the army and building up the CBR’s reserves, the long-term economy growth potential of Russia fell to a mere 2%. Now with the added drag of high interest rates and more punishing sanctions that will be extremely difficult shake off, that growth potential has fallen again to around 1%. Over the coming years Russia’s economic growth will be well below that of the global economy and it will simply fall further and further behind the rest of the world.  

 

Russia’s ability to strike back

The final complicating factor is this is the first time the developed world has imposed sanctions on such a large country that is so deeply integrated into the global market and able to hit back.

The sanctions regime is full of holes as a result of the boomerang effect: many sanctions on Russian industry affect markets so badly that they do as much if not more damage to western businesses as they do to Russia.

As bne IntelliNews reported, even before the war started commodity prices started to spike as tensions rose, but they went through the roof once the fighting began. Nickel trading on the London Metals Exchange (LME) had to be shut down after prices rocket to over $100,000 per tonne from the normal levels of just under $30,000 per tonne. The exchange ended up cancelling all the super high trades and suspended trading for several days until the prices settled at $48,000 per tonne, still almost twice the regular levels.

Aluminium, steel, iron, copper and a slew of other commodities, all produced in Russia, have similar, if not quite so dramatic, stories to tell.  

Indeed, although Russia doesn't hold monopolies in any of these metals (it comes closest to having a monopoly in titanium production, a key component in the aviation industry), it has significant market shares that cause sanctions to rapidly inflate prices and make all the metal exports very hard to sanction without doing significant damage to western economies.  

As a result, many of Russia’s biggest companies have been exempted or passed over when it comes to sanctions. Norilsk Nickel that belongs to oligarch Vladimir Potanin is one company that has yet to be sanctioned. Oleg Deripaska’s aluminium producer Rusal is another one that has not been included in the lists. The last time Rusal was sanctioned in 2014 the price of aluminium soared 40% in a day and the US Treasury Department (USTD) had to delay imposing the sanctions before eventually withdrawing them – the only sanctions to be nixed since the regime was introduced in 2014.

A more recent example was Alisher Usmanov, a metals and tech tycoon, who was included in the personal sanctions list, but many of his companies, especially Metalloinvest that is a major iron producer, were given special exemptions by the US authorities thanks to the impact their exclusion would have on metal prices and the chaos it would cause in the markets.

Wheat is another market where the west is very dependent on Russia. Prices for wheat in the global grain market have already soared to decade-long highs as the war in Ukraine shuts down ports and threatens to disrupt this year’s grain harvest. Between them Russia and Ukraine account for a quarter of global wheat exports and an estimated 7mn tonnes of Ukrainian wheat will be taken out of circulation as a result of the war.  

Actually the problem is not quiet as bad as it first seems as the total global wheat production in 2021 was 779mn tonnes as most wheat is eaten at home, so the missing Ukrainian wheat this year accounts for only 0.9% of total production. Farmers anticipating problems in Ukraine planted more wheat than ususal four months ago so much of the Ukrainian shortfall will be cover by increases in domestic production.  

What problems there are in food distribution will be regional not global and North African is particularly exposed as it relies heavily on Ukraine for its supplies. Egypt is the biggest importer and has been unable to find sellers at at least two tenders held since the war started. Governments in the region and international organisations need to ensure that the conflict in Ukraine does not worsen an already existent food crisis, Human Rights Watch (HRW) said on at the end of March.  

The West is now hunting for alternative suppliers, but given the global nature of the commodities markets Russia will have ample opportunity to find backdoor channels to sell its products to its old customers.

At the same time, Russia will actively seek new customers in the developing world. While the sanctions are mostly imposed by the G7 markets, which represent 80% of global GDP, they also make up less than a seventh of the world’s population. Russia is already actively trading with the rest of world and will actively seek to boost this trade. India has already taken advantage of the buyers' market and cut deals to buy Russian oil and metals at deeply discounted prices. Just how this trend plays out remains to be seen, but Russia is bound to find willing partners in the rest of the world.  

The fact that the rest of the world is so dependent on Russian commodities in itself is a huge hole in the sanctions regime and the sanctions on Russia will change the nature of international trade. EM markets have already been moving away from the dollar slowly, but one of the upshots of the current conflicts is that commodities will play a larger role in country’s reserves and in international trade.  

Zoltan Pozsar, a well-known Credit Suisse analyst and former US Treasury official, said in a recent paper: “We are [now] witnessing the birth of Bretton Woods III – a new world monetary order centred on commodity-based currencies in the East that will probably weaken the Eurodollar system and contribute to inflationary forces in the West…It used to be as simple as “our currency, your problem.” Now it’s “our commodity, your problem”.”

The first signs of this have already appeared. As part of Putin’s rubles-for-gas scheme is the CBR said it would also accept payment for gas in gold and quoted a price of RUB5,000 per gram, effectively linking the value of the ruble, gold and gas. More of these sorts of deals are likely to appear in Russia’s commodity trades.  

The final irony of the conflict is that Russia is likely to make a lot of money from the spike in tensions. The super-high commodity prices will lead to a huge current record account surplus for Russia this year. According to the Institute of International Finance the surplus could reach $240bn this year –double the record $120bn Russia earned in 2021 and 80% of all the CBR money frozen in EU accounts.  

The calculus may change entirely in the coming months. As the West wakes up to the fact that the extreme sanction regime will not cripple the Russia economy, but actually make it money, an effort will begin to put in place new secondary sanctions that prevent the Kremlin use what are bound to become increasingly complicated and sophisticated schemes to avoid the same sanctions. The West will in effect start to play whack-a-mole with Russia’s trade regime. For example, if the West can successfully close down Russian oil exports that will cost the Kremlin about 40% of last year's budget revenues.  

How this game plays out will depend in large part on how willing the rest of the world, and the G20 in particular, is willing to adhere to the West’s sanctions regime. On the one hand India has already done deals to buy Russian oil, gas and other commodities at a deep discount. On the other Chinese banks have refused to issue Russian oil companies letters of credit that under pin oil exports.  

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This article is from bne IntelliNews’ monthly magazine that covers business, economics, finance and politics of the 30+ countries of New Europe.

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